Question 122: "Corporation A" has proposed that each of its top salespeople create an LLC of his or her own, with which the corporation will contract. Each salesperson will be the sole owner of his or her LLC. The corporation hopes to eliminate these individuals as employees and deal with the LLCs on an independent contractor basis. Will that work to keep them out of the corporation's retirement plan? Will the corporation have to pay payroll taxes for these workers?
Answer: If the salespeople are employees now (and it sounds like they are), simply putting in an LLC will not change anything at all for federal tax or pension purposes.
Tax law deals with several classic types of businesses: sole proprietorships, partnerships, corporations, and trusts are the primary categories. At the end of the 20th century, new forms of organization, such as LLCs, burst on the scene. In response, the IRS substantially changed its regulations to create a simple scheme for putting the new square pegs in the old round holes.
Under the new regulations, LLCs can choose to be taxed as corporations. Most do not. If an LLC is not taxed as a corporation and it has more than one owner, it is taxed as a partnership. If the LLC has a single owner, however, the regulations say it is disregarded as a separate entity. In other words, the tax laws ignore the existence of the LLC altogether and tax the owner as a sole proprietor.
So, what this plan does is take a bunch of employees and set up contracts with each to say they are independent contractors. While courts do look to independent contractor agreements in close cases, they are rarely key factors in determining employee status. If there is no real change in operating procedures -- if the corporation has the same level of control over its salespeople as it does now -- then the status of the worker as an employee, rather than as an independent contractor, has not changed.
As a result, the corporation still must withhold taxes from each worker's pay. Moreover, nothing has changed about the worker's status for employee plan purposes, unless the plan excludes workers who are not paid as employees (whether they actually are employees or not). If the plan does have such a clause, the workers would not be participants, but they should still be counted in determining whether the plan meets the eligibility requirements of the Internal Revenue Code.
All in all, it sounds like a poor idea.
For more information on the entity rules and their effect on employee status, see Chapters 1 and 2 of my book, Who's the Employer?, second edition.